Ask the Spud: Should I Hold US Bonds?

March 1, 2012

Q: One of my coworkers and I recently started our own Couch Potato portfolios and we’re wondering if it would be better to have some American bonds in the mix. Wouldn’t that be another way to diversify? – Jason L.

The answer depends on whether you’re talking about government bonds or corporate bonds.

It’s usually not a good idea for Canadians to hold US or other foreign government bonds in their portfolio. In theory, because interest rates are not the same in every country, it can makes sense to diversify your bond holdings globally. However, investing in US or international bonds exposes Canadians to currency risk.

Currency risk is welcome on the equity side of your portfolio, because it can lower volatility without decreasing expected returns. That’s why I recommend using unhedged index funds and ETFs for US and international stocks. But the situation is different for fixed income. The yield differential between Canadian and US bonds is likely to be quite small, and it will be completely overwhelmed by significant changes in the exchange rate. That means adding currency risk to your bond holdings will tend to increase volatility without increasing expected returns. That’s clearly a bad combination. (For an excellent discussion of this idea, see this Vanguard research paper.)

A solution, of course, would be to add currency hedging. That’s what Dimensional Fund Advisors does with its Five-Year Global Fixed Income Fund: “This enables us to gain the benefits that come from diversifying across many countries without measurably increasing currency risk.” However, there are currently no ETFs or index funds that holds US government bonds with the currency hedged to Canadian dollars. So in practice, this asset class is closed to most Canadian investors.

More options for US corporate bonds

The situation is quite different for corporate bonds. There is an even bigger diversification benefit to looking south of the border for this asset class. The Canadian corporate bond market is very small compared with that of the US (especially in high-yield bonds) and the interest rate trends are significantly different in the two countries.

What’s more, there are several index ETFs that allow Canadians to buy US corporate bonds with currency hedging, including the iShares U.S. IG Corporate Bond (XIG), the iShares U.S. High Yield Bond (XHY), and similar offerings from Claymore and BMO. These are reasonable holdings for Canadian investors who want to diversify their corporate bond holdings without taking currency risk.

Got a question about index investing? Send it to mail@canadiancouchpotato.com and it may be answered in a future installment of “Ask the Spud.” Answers are provided as information only and do not constitute investment advice.

TurboTax giveaway

The makers of TurboTax software have offered a free download of TurboTax Premier Online to one lucky reader. The package includes access to free tax advice until May 4. To enter the draw, just leave a comment below before midnight on Sunday, March 4. I will draw a winner at random on Monday.

{ 42 comments… read them below or add one }

Kiyo March 1, 2012 at 8:44 am

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Bill Gates March 1, 2012 at 9:46 am

I would argue that a lot depends on what your investment plans are. If you plan to retire abroad then having a substantial portion of your money in US currency (either in cash or US bonds) makes perfect sense. The US greenback is as close to a universal currency at this point as we can expect to get.

The second reason for having US bonds is that when a panic sets in in the equities market investors run to the safety of US treasuries. Nobody runs into the safety of Canadian treasuries. Regardless of what you think about the trustworthiness of the regime in Ottawa there isn’t even enough room there to absorb a significant portion of the money flowing out of equities. So as a portfolio balancing tool that smoothes out the market bumps, US bonds appear to be much better.

Finally, corporate bonds should not be purchased by anybody ever. What’s the point? If you have faith in a company (or a sector or the whole market index) just buy the equities. Being a corporate bondholder you assume all the risk of investing in a private venture with only a reduced benefit (you get no share in the growth of capital gains).

Dan M March 1, 2012 at 10:04 am

Thanks for the opportunity to win TurboTax Premier Online.

Canadian Couch Potato March 1, 2012 at 10:07 am

@Bill Gates: Thanks for taking a break from your charitable foundation to visit the blog. :)

I agree with your first argument completely. If you have US dollars and want to grow that money with the plan of eventually spending it as US dollars, then it makes perfect sense to invest in US-denominated bonds.

I’m not sure I agree with your second argument. In the event of a market meltdown like we had in 2008–09, Canadian government bonds provided a huge safety net: you didn’t need US Treasurys to get that diversification benefit. It’s true that some exposure to the US dollar would have helped further, but investors could have (and should have) got that exposure on the equity side of their portfolios.

As for corporate bonds, there are many smart folks who agree with you, including David Swenson at Yale, though for different reasons, I think. (Remember that if a company goes bust, its bondholders are first in line and equity holders may get nothing.) Swenson’s argument has more to do with the idea that investors are not rewarded for taking extra credit risk compared with government bonds. I’m more agnostic about this. I think investment-grade corporate bonds are perfectly fine, though not essential, in a diversified portfolio.

Fraser March 1, 2012 at 10:31 am

No insight from me, but would love the TurboTax!

gilbert March 1, 2012 at 11:16 am

The US Bond section of my portfolio I trade using TLT iShares Barclays

Brought TLT in July 2011 $95 US @ 1.05 US. to Cdn.

Sold TLT in November 2011 $120 US @ ).97 US to Cdn.

Capital gain 26% plus 8%-3%(fee)= +5% (currency) = +31% return.

When there is fear & sell off in stocks people run to the safety of US$ & Bonds.

Canadian Couch Potato March 1, 2012 at 11:53 am

@Gilbert: Fair enough, but what you describe is a short-term trade (a four-month holding period), not a long-term strategy.

Francis March 1, 2012 at 12:12 pm

Free Turbo Tax is for me ;)

Philippe V. March 1, 2012 at 12:16 pm

I have also been asking myself this question , but with emerging market bonds that are hedged to Canadian dolars.

What is your opinion about XEB from ishares for example? (http://ca.ishares.com/product_info/fund/overview/XEB.htm).

From what I understood from David Swensen’s book, he did not particularly recommend them, but then I read that Rob Arnott finds Emerging market bonds to be a good investment these days. I am still unsure if they would be a good fit in my portfolio.

Any thoughts on this topic?

SterlingF March 1, 2012 at 12:16 pm

Please include me in the draw. Thanks.

Alex March 1, 2012 at 12:31 pm

I sure could use the Turbo Tax.
Thanks for the opportunity.

Canadian Couch Potato March 1, 2012 at 12:41 pm

@Philippe: The first thing to be aware of is that emerging market bonds are denominated in US dollars, not in their local currencies. And XEB (as well as BMO’s emerging markets bond ETF) hedge the currency. Which is good, since it makes little sense to get US dollar exposure when what you really want is exposure to emerging markets debt.

I put this asset class in the same category as high-yield corporate bonds: a reasonable holding for a small part of a portfolio, but certainly not essential. You mght be interested in Dan Hallett’s take on this:
http://thewealthsteward.com/2012/02/look-past-emerging-markets-bond-funds-sales-pitch/

Erin March 1, 2012 at 4:24 pm

Thanks for the opportunity to enter the draw for the TurboTax Premier Online. I really appreciate your blog too!

Paul G March 1, 2012 at 4:42 pm

Count me in for the draw !

As to bonds, I’m still not entirely comfortable with bond funds, so I’m not going to consider going for US bonds. And given how currency hedging seems to be a major drag on returns, I’d tend to avoid it, though I don’t know if it’s a drag on bonds as much as on equities.

J A H March 1, 2012 at 5:23 pm

Thanks for the contest opportunity and it would be great to hear your thoughts on the new Pimco ETF in an upcoming post.

Dave J March 1, 2012 at 6:55 pm

No comment on this blog but would love the Turbo Tax!

On another note, I just went all in on my own Couch Potato Strategy – finally took the plunge!

Philippe V. March 1, 2012 at 8:05 pm

Thank you for your answer and providing the link to Dan Hallet’s article on emerging market bonds.

This new information has been very helpful in helping me to judge the suitability of emerging market bonds as an investment.

Canadian Couch Potato March 1, 2012 at 8:10 pm

@Paul G: In theory, I would think that the drag from currency hedging should be the same in a fixed-income fund and an equity fund, but I was surprised to see that the two Canadian iShares ETFs that hold US corporate bonds with hedging (XIG and XHY) actually outperformed their US-listed counterparts in 2011, which is surprising. I’m going to look into the reasons why…

@JAH: I will give some thought to the new Pimco ETF and maybe do a post about it. Thanks for the suggestion.

@Dave: Congrats, and welcome to Spudsville!

@Philippe: You’re welcome, glad it helped.

Maxwell C. March 1, 2012 at 9:06 pm

@Paul G: Cozy up to bond funds. The savings (and potential for very easy diversification) therein are amazing!

Adamyoungiam March 1, 2012 at 9:27 pm

Sign me up for turbo tax. Btw love the site

Stephen D March 2, 2012 at 12:00 am

This is a US ETF for Canadian bonds (apparently, its one of a kind):

http://www.pimcoetfs.com/Funds/Pages/CAD.aspx

It seems like a good tool for re-balancing a portfolio while avoiding currency exchange fees (e.g., if you are overweighted in US equity ETFs).

I’d be interested in your thoughts on this fund.

uptoolate March 2, 2012 at 12:10 am

Put me down for the draw. Keep up the great work. Thanks.

Marko March 2, 2012 at 8:45 am

I would like to win the TurboTax Premier Online.

Leo C. March 2, 2012 at 9:53 am

I would love to turbo my tax returns!

Jeff L. March 2, 2012 at 11:09 am

Happy tax season! would love a chance to win turbotax premier!

invest44 March 2, 2012 at 11:14 am

I would like to be in the draw for turbotax.
As for US bonds i am a “couch” potatoe so i want to keep it simple. Adding more layers of investment at some point gets me back to where i was before i became a potatoe.

Arthur March 2, 2012 at 12:20 pm

Turbotax software would be cool.

Thanks for clarifying the benefits of currency risk and hedging for stocks / bonds.

Geoff S March 2, 2012 at 4:17 pm

The interest risk is low in my view. Rates need to say low to keep the US treasury from imploding in debt costs, and the FED will continue to need to provide cheap liquidity. The FED has indicated low rates through 2014. Super-cycle analysis (read the Great Reflation by Tony Boeckh) indicates that the FED can and likely will also move lower for additional stimulus, especially considering the meager state of recovery.

Also free tax software!

Doug Cronk March 2, 2012 at 5:11 pm

Interesting to note that Canadian Pension funds, as per the PIAC average pension asset allocation, have only a 1.76% allocation to foreign bonds. See: http://www.piacweb.org/publications/index.html?theyear=2010
Further, this is the highest allocation ever.
I do not expect to see a significant change in this allocation for the 2011 numbers (available April). (I know, because I have to fill out the darn survey …).
If investors are mirroring a pension plan as their personal investments guide, they need to accept that a foreign bond allocation is a tactical play … as Couch Potato points out and that ‘Gilbert’ provides a perfect example for.
For pension plans the purpose of bonds is to provide a liability match. Interest rate risk is assumed and accepted. Currency risk is not.
Regarding interest rate risk, well, both Governor Carney and the Fed’s Bernanke have indicated that interest rates will remain where they are thru 2012 and 2013.

Canadian Couch Potato March 2, 2012 at 5:40 pm

@Doug: Many thanks for dropping by. This is well put: “For pension plans the purpose of bonds is to provide a liability match. Interest rate risk is assumed and accepted. Currency risk is not.”

Note to other readers: Doug’s blog does a great job of encouraging retail investors to use the same strategies that pension fund managers use. Check it out:
http://dougcronk.wordpress.com/

Ken M. March 2, 2012 at 11:32 pm

Thanks for the draw opportunity.

BC_Doc March 3, 2012 at 2:56 am

@CCP: Interesting post– I think we’re in agreement.

I prefer to keep the risk on the equity side of my portfolio– equities are well diversified using US domiciled Vanguard ETFs (VTI and VEU).

Fixed income I want to keep very boring– even with having roots in the U.S., I’m happy to keep my fixed income 100% Canadian. Safe and boring for this part of the portfolio is fine by me. Now if only I can beat inflation w/my fixed income!

Lincoln March 3, 2012 at 3:49 am

I started my mutual fund couch potato a year ago after finishing university and starting my career. I have currently evened back out recently after about a 10% drop. Crazy how much I’ve learned about investing and even about myself as an investor from doing so. Still new at investing but it’s a start i guess. Thanks for the advice thus far and looking forward to more!

Sampson March 3, 2012 at 11:51 pm

I’m not so convinced that currency hedging by the ETF holding Co’s is effective over the long term. This along with the significantly reduced impact of currency risk on a portfolio over long periods makes me much less hesitant to invest in foreign bonds. I don’t have any exposure now, but will be planning to add some down the road.

I hope I win the Tax program! ;)

Josh March 4, 2012 at 12:21 pm

Count me in on the TurboTax draw. Thanks.

PDF March 4, 2012 at 4:11 pm

Turbo Tax

Ed March 5, 2012 at 12:02 am

Thanks for your time and information.
I am jumping onto the couch.

Owen March 11, 2012 at 1:54 pm

Any idea what kind of withholding taxes I can expect holding US or foreign bonds in an RRSP or TFSA? My understanding is that there is a “tax holiday” on US government bonds that is set to expire soon, would an RRSP be exempt from these taxes anyway?

Canadian Couch Potato March 11, 2012 at 2:41 pm

@Owen: You should not expect withholding taxes on US bond interest at all: the 15% withholding tax imposed by the IRS applies only to dividends. However, I have heard some rumblings that it may eventually be extended to other types of income for US securities. If you’re planning to make a significant investment in US securities, I suggest consulting a tax specialist.

Dil March 13, 2012 at 12:05 am

After reading the vanguard report it seems based all on what the us dollar has done and how it adds volatility compared to other currencies , I’m not sure it’s a good idea to say the same would hold true for the Canadian dollar. The Canadian dollar may move more in line with other foreign currencies and may not add more volatility as the report suggests is the case with the USD.

Meeko July 24, 2013 at 8:41 pm

I am transferring my RRSPs to Questrade and switching over to $US. As part of my portfolio diversification, I was planning on including 3% of each Vanguard Total Bond Market ETF (BND) and Vanguard Total International Bond ETF (BNDX). After reading this posting, I am a bit unsure about whether this is such a good idea considering the currency risk. Should I be concerned with a small % of my portfolio in these funds with a plan for long-term investing?
Merci

Doug Cronk July 25, 2013 at 11:00 am

As of Dec 31/12, the PIAC average asset allocation to foreign fixed income actually DROPPED to 1.5% (from 1.75% at year end 2011). http://www.piacweb.org/publications/index.html?theyear=2012

So much for the rush to foreign bonds.

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